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April 13, 2006

Two Cheers for Loopholes

Joseph J. Thorndike

Joseph J. Thorndike is a contributing editor with Tax Analysts.

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Loopholes are the unloved stepchild of the modern income tax. Two weeks ago Tax Notes published a compendium of complaints, with writers of every stripe making common cause to indict tax incentives. They don't work, we were told. Or they work too well. Either way, we'd be better off without them.

That's a hard case to challenge, at least in contemporary terms. But viewed historically, incentives are not simply an unwanted appendage to the tax system. Rather, they are a vital and necessary component of the income tax, a pillar of the modern tax regime.

Loopholes are as old as taxation itself. In American history, they were a defining characteristic of the tariff, the nation's principal revenue device for more than 120 years. Tariff debates were sometimes waged in general terms, with politicians proclaiming the relative merits of free trade and protectionism. More often, however, tariff arguments were deeply and profoundly specific. Industries lobbied for preferential treatment, and legislators responded by dispensing or withholding favors.

A certain amount of corruption surrounded this process, as one might expect. But often, the details of tariff revision reflected the political imperatives of American politics. Favoritism helped protect the tariff from its opponents, allowing legislators to accommodate the disparate demands of various constituents. That sort of logrolling made the tariff a resilient and durable fiscal tool.

After World War I, the income tax replaced the tariff as the principal source of federal funds. But the political dynamics of revenue extraction remained the same. Steep marginal rates on corporate and individual income made loopholes valuable, especially in the pivotal years after World War I. Rising prices added to the urgency. As historian Elliot Brownlee has observed, "The huge inflation following World War I, between 1918 and 1920, had led to irresistible pressure for new tax preferences."

In the 1920s, Treasury Secretary Andrew Mellon included tax preferences in his campaign to remake the income tax. Defending narrow breaks for corporate America as a means to foster growth, he endorsed broad-based preferences as a political and moral necessity. In particular, Mellon championed an earned income credit, insisting that labor income be taxed more lightly than investment returns.

Mellon understood that modern income taxation required concessions to all interested parties. Different constituencies had to be accommodated, lest the tax system find itself imperiled from above and below. Tax economists of the day were urging lawmakers to adopt a more uniform and consistent base for the income tax; those were the formative years for what we now call the Haig-Simons definition of income. But Mellon and his political bedfellows -- including many Democrats -- were less worried about the purity of an income tax than about its survival.

Of course, the modern income tax emerged not from World War I, but World War II. Millions of new taxpayers joined the system, and they demanded millions -- well, thousands -- of new preferences. Most were reserved for the rich and famous, but others had a more plebian quality. The mortgage interest deduction was a principal concession - - a feature of the tax system since 1913, it took on new importance as homeownership soared in the postwar era. Similarly, the tax-free treatment of health insurance benefits found a broad constituency once unions made employer-provided insurance a fixture of the modern labor market.

Lawmakers believed that preferences were a crucial prop for the income tax. Once regarded as a rich man's burden, the tax had become a middle-class reality during the war. As two legal scholars later remarked, it had "changed its morning coat for overalls." Lawmakers took pains to ensure that middle-class taxpayers felt comfortable in their new clothes, letting out the seams with a variety of tax preferences and incentives.

In other words, tax incentives were a functional necessity during the formative years of the modern tax regime. But in the decades after, they began to undermine the system. Steep marginal rates created a steady demand for loopholes, especially as inflation once again fueled a process of bracket creep. By 1967 the revenue loss from tax preferences equaled 21 percent of total direct expenditures, according to Brownlee. By 1984 the figure had risen to 35 percent. Preferences were getting expensive, threatening the adequacy of federal revenue.

Perhaps more important, the accretion of incentives vitiated the apparent fairness of the income tax. By the 1980s, tales of widespread tax avoidance had combined with complexity complaints to set the stage for sweeping reform. The Tax Reform Act of 1986 managed to clean out some of the fiscal detritus. But the dynamics of tax policymaking remained intact. And as economist Milton Friedman has observed, the end result of base broadening is just a renewed opportunity for lawmakers to resell old tax preferences.

Some observers believe loopholes will be the undoing of the income tax, undermining fairness to the point where wholesale reform finds a real constituency. Certainly many consumption tax proposals, including the flat tax and the national retail sales tax, seem to draw on a sense of crisis driven by the proliferation of preferences.

But so far, loopholes seem to be doing their job, protecting the income tax from its most vocal critics. Proposals for fundamental reform seem to founder regularly and reliably whenever talk turns to mortgages, health insurance, or other treasured incentives. For conservatives, of course, that's the whole problem: Incentives work entirely too well, buying off voters who might otherwise be mad as hell.

But liberals should be careful when they condemn tax preferences. The ideal of a clean -- even pristine -- income tax may seem appealing. But the messy reality may be unavoidable.